"Returning cash to shareholders" is a phrase often used to describe a company's paying a dividend or employing a share repurchase program. While paying a dividend is a clear example of returning cash directly to shareholders and boosting total returns, as Seeking Alpha contributor Ploutos recently noted in the article "Buying Buybacks," "the efficacy of share repurchases in driving investment results has historically been a source of debate." Nevertheless, in that article, Ploutos posted the following chart, which illustrates the extent to which the "S&P 500 Buyback Index" (total return) has outperformed the S&P 500 (total return) over time.
Ploutos indicated that in the coming weeks, he/she will write a series of articles dissecting the one hundred constituents of the S&P 500 Buyback Index in order to answer the question of which types of companies (or which companies specifically) most often benefit from share repurchases. I hope those articles help provide insight into why it is the S&P 500 Buyback Index has outperformed the S&P 500 by such a large extent since around the turn of the millennium. But there are factors, which will not be uncovered by a dissection of the index constituents themselves, that contribute to the outperformance of the S&P 500 Buyback Index. In this article, I would like to discuss those factors.
Whenever I come across an index that outperforms other indices, my attempting to uncover why the outperformance is occurring focuses on two areas. One of those areas is an examination of the constituents themselves, an exercise Ploutos will be performing for the Seeking Alpha community. The other area is an examination of index methodology. The approach itself to constructing an index might lead to or contribute somewhat to that index's outperformance. In the case of the S&P 500 Buyback Index, I think index methodology has been playing a role in its outperformance.
Concerning index construction, there are two steps to building the S&P 500 Buyback Index: constituent weightings and constituent selection.
The S&P 500 Buyback Index is an equal weighted index, meaning that each constituent is given the same weighting (importance) in the index. This is fundamentally different from the construction of the S&P 500, which is not an equal weighted index. Instead, it is a capitalization-weighted index, which means the constituents are weighted according to their market capitalization. This causes larger market-cap constituents to carry larger weightings in the index and smaller market-cap constituents to carry smaller weightings. Upon learning of the difference between how the S&P 500 and the S&P 500 Buyback Index weight constituents, the first thing I did was compare the performance of the S&P 500 cap-weighted index to the performance of the S&P 500 equal-weighted index. I wanted to see if the equal-weighted index had notable outperformance during the time in which the S&P 500 Buyback Index was notably outperforming the S&P 500. It turns out it did.
Notice RSP's extreme outperformance during the time period selected, and, might I add, notable underperformance during the last bear market. It should be noted that RSP holds all 500 stocks included in the S&P 500 as opposed to the S&P 500 Buyback Index, which is designed to track 100 constituents from the S&P 500. But as the chart demonstrates, since 2003, an equal-weighted index of S&P 500 constituents has notably outperformed a market-cap-weighted index of S&P 500 constituents. In other words, there was investment value derived from equal-weighting S&P 500 constituents over the past 10 years. That corresponds well to the period during which the S&P 500 Buyback Index began to dramatically outperform the S&P 500 (as illustrated in the Bloomberg chart above). I contend that some portion of the S&P 500 Buyback Index's outperformance has been due to its equal-weighted construction.
As the Forbes article "No Free Lunch From Equal Weight S&P 500" notes, from 2003 to 2012, an S&P 500 equal-weighted index returned 10.2% annually versus the cap-weighted S&P 500's 7.1% annualized return. On the other hand, from 1990 to 1999, the S&P 500 cap-weighted index returned 18.2% annually, while the S&P 500 equal-weighted index returned just 15.1% annually.
Additionally, by equal-weighting instead of cap-weighting an index of S&P 500 constituents, the average market capitalization of the index will drop. If equal-weighting the S&P 500 lowers the average market capitalization of the index, and if an equal-weighted index of S&P 500 constituents notably outperformed the S&P 500 cap-weighted index over the past decade, we should also expect that broad small- and mid-cap indices would have outperformed the S&P 500 during the same time frame. Sure enough, that was the case. The chart below shows the performance of SPY compared to the performance of the iShares Russell 2000 ETF (NYSEARCA:IWM), a small-cap ETF, and the performance of the SPDR S&P MidCap 400 ETF (NYSEARCA:MDY). The chart dates back to IWM's inception date and corresponds well with the time frame in which the notable outperformance of the S&P 500 Buyback Index occurred.
With all this in mind, is the average market cap of the S&P 500 Buyback Index lower than the average market cap of the S&P 500? Yes. As of June 28, 2013, the average market cap among S&P 500 Buyback constituents was $23.34455 billion, 23.09% lower than the $30.35484 billion average market cap among S&P 500 constituents.
To review, we know that during the time period in which the equal-weighted S&P 500 Buyback Index notably outperformed the S&P 500, an equal-weighted S&P 500 index also notably outperformed the S&P 500. We also know that the during the time period in which the S&P 500 Buyback Index notably outperformed the S&P 500, small- and mid-cap indices were also notably outperforming the S&P 500. Interestingly, the S&P 500 Buyback Index currently has an average market cap that is roughly 23% lower than the S&P 500's. Again, I contend that the S&P 500 Buyback Index's outperformance has been aided by its equal-weighted construction.
I previously mentioned that the S&P 500 Buyback Index is designed to track 100, rather than 500, constituents. According to the "S&P 500 Buyback Index Methodology," the 100 constituents with the highest buyback ratios are chosen for the index. More specifically:
"Assuming a 3-month lagging period for the release of company reports at each reference date, the observation period for the calculation of the buyback ratio is defined as the 12-month (or 4-quarter) period ending 1 quarter before the reference date. The buyback ratios of the S&P 500 constituents are calculated as the monetary amount of cash paid for common shares buyback during the observation period divided by the total market capitalization of common shares at the beginning of the observation period. Constituents then are ranked in descending order based on the buyback ratio. The top 100 securities form the index."
The June 19, 2013 "FactSet Buyback Quarterly" includes the following chart of quarterly share repurchases by S&P 500 companies (chart also included in Ploutos' aforementioned article).
According to FactSet, the dollar value of share repurchases was $97.8 billion during Q1 2013 and $399.9 billion during the trailing twelve months ending March 31, 2013. But even though some well-known companies may be putting up billions of dollars to repurchase shares each quarter, compared to just millions of dollars put up by other companies, remember that it is the ratio of the monetary amount of cash paid to the total market capitalization that matters for inclusion in the S&P 500 Buyback Index. This helps level the playing field for lower market-cap companies and can help lower the average market cap in the index. As I discussed in the "Constituent Weightings" section of this article, an overall skew toward lower market-cap weightings has been advantageous from an investment return perspective over the past decade or so.
In addition to index construction (constituent weightings and constituent selection), index maintenance might also be providing a role in the S&P 500 Buyback Index's outperformance. If you believe in the concept of buying low and selling high, then the S&P 500 Buyback Index's maintenance policy may be providing additional alpha. By rebalancing on a quarterly basis, the index is effectively buying low and selling high.
Additionally, by continually including only those S&P 500 constituents that have the largest buybacks as a percentage of their market caps, the S&P 500 Buyback Index is also regularly replacing those companies that have seen their share prices rise (market cap rises, thereby putting downward pressure on the buyback ratio). The index is then replacing those companies with other companies that one might argue see more value in their stocks given their larger buyback ratios. This can also act as a type of buy low, sell high strategy.
When researching why it is one index has outperformed another, it is important not just to examine the constituents that make up the indices but also to examine index methodology. In the case of the S&P 500 Buyback Index, I contend there are multiple factors contributing to its outperformance. It may be easy to assume that if the index has the word "Buyback" in its title, share repurchases are the driving force behind its outperformance. While I think share repurchases are likely playing a role in the S&P 500 Buyback Index's outperformance, I think the index's methodology also plays a rather large role in its success. On a final note, I also think the index's methodology will one day help to contribute to the index's underperformance. But that is a topic for another day.